Rite Aid, Walgreen, and CVS: Growth Becomes the New Driver

As most of the market’s big momentum movers are trading lower, Walgreen, CVS, and Rite Aid keep giving reasons to buy.

CVS Caremark(NYSE:CVS) and Walgreen(NASDAQ:WBA) have both been strong market performers over the last couple years, and their smaller peer Rite Aid (NYSE:RAD). has been among the top performers of the S&P 500 since late 2012. This industrywide performance is not without reason, and in looking ahead to 2014, it now appears another catalyst has emerged, which could take these stocks even higher.

2013: The year of margin expansionSince the end of 2012, CVS, Walgreen, and Rite Aid have significantly outperformed the S&P 500 index. Yet, despite this top market performance, none of the noted stocks trade at a lavish multiple.

Company

Stock Performance Since December 2012

P/E Ratio

CVS

60.3%

20

Walgreen

85.5%

23.6

Rite Aid

525%

22

S&P 500

33%

The reason that CVS, Walgreen, and Rite Aid have been able to return such large stock gains while keeping their P/E multiples in check is because of significant margin expansion. It is this margin improvement that really helped shares to catapult higher in 2013.

Company

Operating Margin 2012

Operating Margin Last 12 Months

CVS

5.5%

6.3%

Walgreen

4.8%

5.1%

Rite Aid

(1.4%)

3.7%

While each company made operational improvements and modifications to their existing business, the cause for margin expansion was more related to a macro shift from brand name to generic drugs. Essentially, brand drugs have large markups from the manufacturer and leave little profits for pharmacies.

However, between 2011 and 2016, $133 billion in brand drug sales have or are losing patent protection, which then introduces cheaper generic drugs. These generics allow for larger returns to pharmacies because of both pricing and the ability to buy in bulk, which lowers costs.

For Rite Aid in particular, this rise in margin took the company from near bankruptcy to now thriving, and its stock is a reflection of this performance. In a recent article, I used quotes from these companies' CEOs to show how generics have affected each business and also the exceptional year(s) that could be ahead with major brand drugs losing patent protection. Hence, margins should continue to go higher.

2014: Even more margin expansion (and growth)2014 is already looking like a mirror of last year, as CVS, Walgreen, and Rite Aid have all significantly outperformed the S&P 500 index.

Company

2014 Stock Performance

CVS

5%

Walgreen

17%

Rite Aid

30%

S&P 500

2%

Now, what's really exciting about 2014 is that aside from expectations of continued margin growth, all of the noted companies are also experiencing revenue growth. For Rite Aid in particular, revenue has fallen in each of the last two years.

However, in the first three months of this year, Rite Aid's same-store sales have increased 2.9%, 1.5%, and 0.7%, respectively. While the 0.7% rise in March shows that Rite Aid's growth has slowed, it's important to note that Easter was in March last year. But, more importantly, Rite Aid's pharmacy business saw sales rise 4.2%, 3.1%, and 3.5%, respectively, in the first three months of this year. Collectively, this shows that Rite Aid is now growing.

In comparison, Walgreen, which does have a recent history of growth, saw its same-store sales rise 3.7% in January and then 4.5% in the last two months. Like Rite Aid, Walgreen's pharmacy business has been a key catalyst, growing nearly 9% in March. This unexpected growth has served as a springboard for the stock trading higher.

Lastly is CVS, which hasn't yet reported March sales but did see overall revenue increase 4.2% in its recent quarterly report, including pharmacy growth of 5.2%. Overall, this complements the performance of its peers and is a good reason to believe that each stock could continue to trade higher this year.

Final thoughtsCVS and Walgreen are large, well-established leaders in this space whose fundamental performance is a great indication of the overall health of the industry. And while neither company is particularly expensive, Rite Aid is a recovery story, and in that recovery might be significantly more upside potential.

Rite Aid still has the most to gain in margins and is already substantially cheaper than its peers relative to sales. For example, CVS and Walgreen trade at 0.7 and 0.8 times sales, respectively, yet Rite Aid trades at only 0.2 times sales. This discount allows for more upside; and as margins improve and growth occurs, it should continue to outperform its peers.

Author

Brian Nichols is the author of "5 Simple Steps to Find the Next Top-Performing Stock: How to Identify Investments that Can Double Quickly for Personal Success (2014)" and "Taking Charge With Value Investing (McGraw-Hill, 2013)". Brian is a value investor, but emphasizes psychology in his analysis. Brian studied psychology in undergrad, and uses his experience to find illogical value in the market. Brian covers technology and consumer goods for Motley Fool. Brian also updates all of his new and current positions in his Motley Fool CAPs page. Follow Brian on Twitter and like his page on Facebook for investment conversations and recent stories. Follow @bnichols9883